Introduction to Imperfectly Competitive Markets: Study Guide (Microeconomics 4.1)

From perfect competition to market power

In Unit 3 you studied perfect competition: many firms sell an identical product, anyone can enter or leave, and each firm is a price taker. One wheat farm cannot change the market price, so it can sell as much as it likes at that price.

Most real markets are not like this. Your town may have one water company, a handful of mobile networks and dozens of cafés that each sell a slightly different coffee. In all of these, a firm has some control over its price. Economists call this market power, and markets where firms have it are imperfectly competitive.

The firms still have the same goal: maximise profit. What changes is the market structure around them. That structure limits what prices they can charge, how much they produce and how efficient the result is.

The four market structures

The course uses four models of product markets. Three of them are imperfectly competitive.

Feature	Perfect competition	Monopolistic competition	Oligopoly	Monopoly
Number of sellers	very many	many	a few large firms	one
Product	identical	differentiated (brand, style, location)	identical or differentiated	unique, no close substitutes
Barriers to entry	none	low	high	very high
Demand curve facing the firm	horizontal at the market price	downward-sloping	downward-sloping; depends on rivals’ choices	downward-sloping; it is the market demand
Control over price	none (price taker)	some	considerable	considerable (price maker)
Long-run economic profit	zero	zero (entry competes it away)	possible	possible
Price compared with MC at the chosen output	P = MC	P > MC	P > MC	P > MC

There is also an imperfectly competitive structure in factor markets (markets for labour, land and capital). A monopsony is a market with a single buyer, such as one large employer that hires almost all the workers in a remote mining town. You will study it in Unit 5.

Why a firm must cut its price to sell more

A perfectly competitive firm faces a horizontal demand curve at the market price. Every extra unit sells for the same price, so its marginal revenue (MR), the extra revenue from one more unit, equals the price: P = MR.

An imperfectly competitive firm faces a downward-sloping demand curve. If it wants to sell more, it must lower its price. With no other changes in the market, and the same price charged to every buyer, the lower price applies to every unit it sells, not only the extra one.

So when the firm sells one more unit, two things happen:

1. Quantity effect (gain): it receives the new price for the extra unit.
2. Price effect (loss): it receives less on all the units it was already selling.

MR = new price − (price cut × number of units sold before)

Because the price effect is a loss, MR is less than price for every unit after the first. On a graph, the MR curve lies below the demand curve. This is true for monopoly, oligopoly and monopolistic competition alike.

Two more facts follow from this:

• Total revenue rises while MR is positive and falls once MR is negative. It is largest where MR = 0. From Topic 2.3, this means demand is elastic where MR > 0 and inelastic where MR < 0.
• For a straight-line demand curve, the MR line starts at the same point on the price axis and is twice as steep. It reaches zero halfway to where demand meets the quantity axis.

Price above marginal cost: why these markets are inefficient

Buyers keep buying until the marginal benefit of one more unit equals the price. So the price tells you what the last buyer values the good at.

In perfect competition, firms produce until P = MC. The value of the last unit to buyers equals its cost to produce. No unit worth more than it costs is left unmade, so the market is allocatively efficient.

An imperfectly competitive firm stops earlier. It produces only while an extra unit adds more to revenue than to cost, and because MR is below price, it stops at a quantity where P > MC. At that point:

• the next unit is worth more to some buyer (about P) than it costs to make (MC);
• both sides could gain from making it, but the firm will not, because making it means cutting the price on all its other units;
• so the quantity is too low and the price too high compared with the efficient outcome.

Buyers and sellers are responding to a price that sits above marginal cost. The value lost on the units that are never produced is a deadweight loss. In Topic 4.2 you will measure it as an area on a graph.

Barriers to entry

In perfect competition, economic profit attracts new firms, supply rises, and profit is competed away. Imperfect competition can last only if something stops that process. A barrier to entry is anything that makes it hard for new firms to join a market.

Barrier	How it works	Generic example
High fixed or start-up costs	a new firm must spend a large sum before selling anything, and it cannot spread that cost over many sales at first	a steel mill, a railway, a national power grid
Legal barriers	the law lets only certain firms sell	patents on a new invention, copyright, a government licence or franchise to run a service
Exclusive ownership of a key resource	one firm controls an input the others need	the only quarry of a rare stone in a region

The higher the barriers, the fewer the firms and the more market power each one keeps. Low barriers (monopolistic competition) let entry erode profit over time. High barriers (oligopoly, monopoly) can protect profit in the long run.

Similarities, differences and limits of the models

• Same goal: every firm in every structure tries to maximise profit, and every one uses the same marginal thinking from Unit 3.
• Key difference: only the price taker has P = MR. All others have MR below the demand curve, so all of them end up with P > MC.
• Limits: the four structures are models, not boxes that every market fits neatly. Whether a firm is a “monopoly” depends on how you define the market. The only bookshop in a town may compete with online sellers. Real markets often sit between two models, so you choose the one that best explains the features you care about.

Worked example 1: marginal revenue at Hollin Pottery

Question. Hollin Pottery (fictional) makes hand-painted mugs that buyers see as different from other mugs. It charges every buyer the same price. Its daily demand schedule is below.

Mugs per day	1	2	3	4	5	6	7	8
Price ($)	18	16	14	12	10	8	6	4

(a) Find total revenue (TR) and MR at each quantity. (b) Split the MR of the 4th mug into a quantity effect and a price effect. (c) At what quantity is TR largest? What does this tell you about demand above and below that point?

(a) TR = price × quantity. MR = change in TR from one more mug.

Mugs	1	2	3	4	5	6	7	8
TR ($)	18	32	42	48	50	48	42	32
MR ($)	18	14	10	6	2	−2	−6	−10

After the first mug, MR is below the price at every quantity. For example, the 4th mug sells for $12 but adds only $6 to revenue.

(b) To sell 4 mugs instead of 3, Hollin cuts the price from $14 to $12.

1. Quantity effect: the 4th mug brings in +$12.
2. Price effect: the first 3 mugs now earn $2 less each: 3 × $2 = −$6.
3. MR = 12 − 6 = $6. This matches 48 − 42 from the table and Figure 2.

(c) TR is largest, $50, at 5 mugs. Up to 5 mugs, MR is positive, so a price cut raises TR: demand is elastic. Beyond 5 mugs, MR is negative, so a price cut lowers TR: demand is inelastic. For the 6th mug, the quantity effect (+$8) is smaller than the price effect (5 × $2 = −$10).

Check. The demand line meets the quantity axis at 10 mugs. Revenue peaks at 5, halfway, as the straight-line rule predicts.

Worked example 2: why Hollin stops at four mugs

Question. Each extra mug costs Hollin $5 to make (constant MC). Hollin currently sells 4 mugs a day at $12. (a) Compare price and MC at 4 mugs. (b) A buyer would pay $10 for a 5th mug. Is making it good for society? Why does Hollin not make it? (c) What quantity would be allocatively efficient?

(a) P = $12 and MC = $5, so P > MC by $7. The last buyer values a mug at $12; it costs only $5 to make.

(b) For society: the 5th mug is worth $10 to a buyer and costs $5 to make, so it would create $10 − $5 = $5 of extra value.

For Hollin: to sell it, Hollin must cut the price to $10 on all 5 mugs. MR of the 5th mug is only $2 (from the table), but MC is $5. Hollin’s profit would fall by 5 − 2 = $3. Check: revenue minus variable cost is 48 − 20 = $28 at 4 mugs and 50 − 25 = $25 at 5 mugs.

So the gain to society is real, but the firm will not capture it, because the price cut on the other units costs more than the extra mug earns.

(c) Efficiency needs P = MC, or the last unit for which buyers’ value is at least MC. The 7th mug sells at $6 ≥ $5; the 8th would sell at only $4 < $5. The efficient output is 7 mugs. Mugs 5, 6 and 7 are worth more to buyers than they cost, but are not made. That missing value is the deadweight loss.

Interpretation. The inefficiency does not come from Hollin being careless. It is a profit-maximising response to a downward-sloping demand curve.

Worked example 3: naming the barrier

Question. For each fictional market, name the main barrier to entry (if any) and say whether high profits are likely to last.

(a) Trevane Pharma holds a patent on a new allergy inhaler. (b) Building a cement plant costs hundreds of millions of dollars, and the region of Ardley has room for only two plants that can sell enough to cover that cost. (c) Corrin Minerals owns the only known deposit of a mineral used in a type of ceramic. (d) A city has 60 food stalls, and a new stall needs only a small permit and a cart.

(a) Legal barrier. The patent stops rivals from selling the same inhaler for the life of the patent. Profit can last until it expires or until rivals invent a substitute.

(b) High start-up costs. A new entrant would face huge fixed costs and could not sell enough to cover them. Profit can last; the market is likely to be an oligopoly with two firms.

(c) Exclusive ownership of a key resource. Rivals cannot get the input. Profit can last unless a substitute input is found.

(d) Low barriers. If stalls earn economic profit, new stalls will open and compete it away. This looks like monopolistic competition: many sellers with slightly different food.

Common misconceptions

• “Imperfect competition means firms are badly run.” It describes the market structure, not the managers. These firms maximise profit just as price takers do.
• “MR equals price for every firm.” Only for a price taker. With a downward-sloping demand curve, MR is below price after the first unit.
• “MR is below price because the firm’s costs rise.” MR is about revenue only. It is below price because the price cut applies to the units already being sold.
• “A monopoly can charge any price it likes.” It still faces the demand curve. A higher price means it sells less.
• “P > MC means the firm is making a profit.” P > MC is about efficiency at the margin. Profit depends on price compared with average total cost.
• “Monopsony is another name for monopoly.” A monopoly is a single seller; a monopsony is a single buyer, usually of a factor such as labour.

Where this leads

Next you will use these ideas to build the full model of a single seller in Topic 4.2, Monopoly, where the firm picks its output where MR = MC and you calculate profit, surplus and deadweight loss. Test yourself with the practice questions, then use the revision notes and the checklist to consolidate.